An Overview of Cryptocurrency

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Photo by Karolina Grabowska from Pexels

While there have been many attempts in the past to create a digital cash system none had the solutions for the problems it presented – most importantly how to keep transaction records secure and accurate without a single authority overseeing the whole operation.

In 2008 an entity going by the name “Satoshi Nakamoto” had announced in its paper “Bitcoin: A Peer-to-Peer Electronic Cash System” the first digital currency that would not be affected by traditional centralized authority. The following year January Bitcoin launched. In the paper was also the technology that would keep it decentralized, secure, fair, and accessible for all known as “blockchain” – this was the final piece of the puzzle that no one had thought of.

With these two inventions Satoshi laid the groundwork for cryptocurrencies (or crypto) – digital assets that could be used to purchase goods and services as well as investment.

What is it?

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Photo by Roger Brown from Pexels

Cryptocurrency is an internet-based medium of exchange using cryptographical functions to for various purposes. It uses blockchain technology for a highly-secured decentralized online ledger that is also public. While they are considered digital currency their general acceptance, trust, and use in mainstream society is low due to their highly volatile nature and no regulation.

There is no bank or government that controls cryptos. As a result they are worth what people are willing to pay or exchange for it.

The “crypto” part of “cryptocurrency” is due to the consensus-keeping process being secured via strong cryptography. Built on this they are not secured by people or by trust, but by math.

Cryptography is used in two different ways concerning cryptocurrencies:

  1. Hashing. This function serves to check data integrity, blockchain structure, secures people’s account details and transactions, and is used to create the mathematical puzzles that miners solve to create new cryptocurrency.
  2. Digital signatures. Enables use of encrypted information without its details being revealed. For cryptocurrency it allows signed monetary transactions and displays ownership.

Properties of Cryptocurrency include:

  • Irreversibility. Any transaction after confirmation cannot be undone
  • Anonymity. No transaction or account is tied to real-world identities. You receive Bitcoins on addresses which are chains of 30 characters. While transaction flow can be analysed connecting real-world identities to addresses is usually not possible.
  • Fast and Global. Just like e-mail is to mail location does not affect cryptos.
  • Secure. Crypto funds are locked in a public key cryptography system. Only one with a private key can send crypto.
  • Permissionless. No need to ask anyone to access crypto. It is software you download for free, after which you are able to send and receive cryptos.

Due to the combination of these properties crypto are revolutionary in that they are an irreversible, anonymous, and permissionless exchange medium; they rival bank and government control over how their citizens conduct monetary transactions.

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Photo by Roger Brown from Pexels

While it was the first it did not mean that it was the best. Bitcoin had its flaws and so there were altcoins created to alleviate its flaws

  • Ethereum. Differing from Bitcoin as its blockchain can confirm so-called states. This means that it can work for complex contracts and programs. After the hack on the smart contract DAO the developers created Ethereum Classic without consensus. In reality Ethereum is made up of a number of tokens making it more a family than just one currency.
  • Ripple. More a network to process IOUs. Its cryptocurrency (XRP) protects the network from spam more so than acting as a storable and exchangeable medium. With all its coins pre-mined Ripple found value in the financial space as many banks have joined its network.
  • Litecoin. If Bitcoin was gold then Litecoin was its silver. Faster, more tokens, and a new mining algorithm made it valuable as an alternative and backup to Bitcoin. It helped other cryptocurrencies grow as they modified Litecoin’s codebase to be leaner.
  • Monero. In the Bitcoin blockchain you could find the flow of transactions. Monero introduced ring-signatures with its CryptoNight algorithm that blocked that from happening. While other CryptoNight variants had been created none stood out as Monero did.
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Photo by Worldspectrum from Pexels

With the amount of investment cryptocurrencies have had there’s been developments to address the concerns of stability and volatility. Stablecoins are crypto that, with special cryptography, remain price stable. There are three types of stablecoins: fiat-backed, crypto-backed, and algorithm-based (seignorage). The reasons as to why stablecoins are so attractive are:

  • Offering the benefits of fiat and crypto, ensuring price stability, and also the advantages of blockchain technology.
  • That Decentralized Finance (DeFi) can use them easily with other DeFi products/ applications. Known as the future of finance it is also one of the biggest reasons for blockchain adoption.
  • Faster international and cross-border payments.

Another evolution of the cryptocurrency are Central Bank Digital Currencies or CBDCs. CBDCs allow cryptocurrency into the mainstream via a digital version of fiat money able to be used as legal tender, generated by the country’s central bank. There are many advantages to this:

  • CBDCs can lower the cost of making cash for countries that are secluded on an island.
  • Traditional financial systems are usually bogged down by many processes that ultimately result in higher risks and fees.
  • An inclusive financial system can be created using CBDCs as there are many in the world that do not have a bank account.
  • A domestically-issued CBDC denominated in the domestic unit of account would be able to counter privately-issued currencies which can run into regulatory issues.
  • With CBDCs governments can use a private blockchain to control price volatility; while this is against decentralization it will promote widespread usage of the technology.
  • Increasing the response of the economy during policy rate changes.
  • Increased competition and innovation within the financial space, as well as allowing small and non-bank entities to have their payments not go through the large banks.
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Photo by David McBee from Pexels

As with any new and emerging product many things have been said concerning cryptocurrency and the industry as a whole that aren’t true or blow things out of proportion:

  • Only bad guys use them. Anonymity is one of the selling points for cryptocurrency and it is true that criminals get away with using cryptocurrencies. However, there are also cases where corrupt governments and banks have destroyed the value of fiat currency. This is where cryptocurrencies can play a role as no entity, no matter how powerful, can determine the value of it nor can they remove it.
  • Anonymous transactions. Despite the buzzwords and phrases that are flung around willy-nilly anonymous transactions depends on the cryptocurrency. Bitcoin, for example, have their transactions on a public blockchain meaning that anyone can view the transaction history.
  • Blockchain is only useful for cryptocurrencies. At its basis Bitcoin is just one example of how a blockchain may be utilized.

How Does it Work?

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Photo by Alesia Kozik from Pexels

The creation of cryptocurrency requires “mining” by computers solving mathematical problems.

Due to decentralization there is no power in place to force one to become a miner and stop abuse. To prevent this Satoshi set a rule requiring miners to find a hash using some of their computer’s power. A hash is a cryptographic function that connects a new block with its predecessor. This is known as proof-of-work.

In Bitcoin the hash is based on the SHA 256 Hash algorithm. By itself its not important but for miners it can be part of a cryptographical puzzle that they compete against one another to solve. If successful a miner can build a block and add it to the blockchain.

Technically anyone can mine cryptos – It’s just that many already have the equipment to efficiently mine to a degree that most have no chance of gaining anything. Bitcoin farms take up an estimated 0.21% of the world’s power – roughly the amount Switzerland uses annually.

Miners are the only ones who can confirm transactions. They take transactions, stamp them as legit, and spread it to the network. After confirmation every peer (node) must add it to their database and it becomes part of the blockchain

An example of a transaction would be “Bob gives X Bitcoin to Alice”, and it is signed by Bob’s private key – basic public key cryptography. After it is signed its broadcasted in the network to every peer. This is basic peer-to-peer technology.

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Photo by Alesia Kozik from Pexels

To verify transactions there are two methods: proof-of-work and proof-of-stake.

Proof-of-work involves a participating computer or a “miner” solving mathematical puzzles that check the integrity of a block of transactions. Once done it is added to the blockchain and those who finish first gain cryptocurrency tokens. As the puzzles themselves are complex the race consumes power that, even with the amount of crypto they gain, may not equate with the costs.

Proof-of-stake limits the amount of transactions one may verify according to how much they “stake”. While you may be chosen someone who has staked more will be in a better position to do so.

An incentive to miners who can solve the puzzles have the right to add a so-called coinbase transaction that gives them a specific number of Bitcoins. It is this process that is the only way to create valid Bitcoins. Due to the puzzle’s difficulty the whole miner’s computer power must match it, allowing only a specific amount of crypto token to be created in any given amount of time. This is part of the consensus no peer in the network can break.

Purchasing crypto is determined by the crypto themselves – some can be bought with US dollars and some must be bought with other crypto. Just as you would hold the odd dollar bills in a wallet you hold crypto in a digital wallet. Crypto exchanges usually allow you to create an account and purchase crypto with transferred real money. Online brokers are also slowly warming to offering crypto.

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Photo by Karolina Grabowska from Pexels

The Blockchain

In the beginning the problem with decentralized networks was how to keep every peer on the network on board with every single transaction. If there was even just one peer that had a problem the whole system is broken.

Blockchain technology solves the issue by allowing the creation of an unchangeable, decentralized, public, and accurate record of transactions. Each group of transactions is a “block” that is “chained” to the previous. Each user or “node” of the network downloads and manages the blockchain automatically. This technology is another of Satoshi Nakamoto’s inventions and its use is slowly spreading outside of crypto.

Investing in Cryptocurrency

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Photo by Karolina Grabowska from Pexels

While crypto is slowly gaining value as an actual currency its been far more known for its role of speculation and stored value to a degree that none have come close to. Investors and those alike trade hundreds of cryptocurrencies daily in fast and dynamic-growing markets that far outpace major stock exchanges.

If you were to gain a profit someone would have had to pay more than what you did; this is known as “the greater fool” theory of investment. A dilemma await those who have cryptocurrency – do you sell now avoiding a potential loss in investment or do you hold on for when it may increase in value?

Whether you become a passive or active trader a plan will help you structure your actions so that you don’t go out of control.

  • While the market is still new and developing spreading your investment over 15 crypto of different categories can level your chances of having a positive portfolio.
  • Analyzing the best time to buy and sell is integral to making profit and reducing your losses.

There are ways to protect yourself when buying crypto in an ICO:

  • If the owner is largely unknown then be wary.
  • Who are the investors? Are they well known?
  • Are you just purchasing currency or will you gain a stake in the company?
  • Is its development complete or are they looking for funds to finish it?
  • Is their prospectus detailed or brief?
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Photo by Alesia Kozik from Pexels

Even with all these questions answered positively or negatively, fully or briefly, the success a crypto will have in its future is unknown until it hits the market – and even then it will be up in the air as many have fallen by the wayside while others have found the limelight.

While on the fringe of the general public there are entities that are experimenting with the option to pay using crypto. As there is no singular authority the value of any crypto can take drastic changes. Investing is dangerous and more so for crypto.

A long-term investment with crypto is unpredictable as it is exchanged peer-to-peer unknown to any regulatory standard, unlike a growth stock mutual fund where you are able to analyze patterns.

If you aren’t in any debt, have emergency savings that will cover you sufficiently for a while, and are investing in growth stock mutual funds you could take the plunge and play with crypto.

Conclusion

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Photo by Alesia Kozik from Pexels

Cryptocurrency (or crypto) is decentralized digital money based on blockchain technology. While you are able to buy regular goods and services it can also be used for investment as you would for other assets like stocks or precious metals.

The risks that come with crypto is mainly due to their volatility. As speculators, the community, and investors directly influence the value you may lose or win big. Research is key but even with all the knowledge gathered no one will know until they hit the market, and even then over its lifespan the value can be unpredictable.

Whether or not crypto becomes an integral part of the future will be decided not by any central authority but by the people who see it as valuable and invest their own resources into it.

References

Ashford, K. and Schmidt, J., 2020. What is Cryptocurrency? – Forbes Advisor. [online] Forbes.com. Available at: <https://www.forbes.com/advisor/investing/what-is-cryptocurrency/>.

Chris Hogan. n.d. 4 Things to Know Before Investing in Cryptocurrency. [online] Available at: <https://www.chrishogan360.com/investing/investing-in-cryptocurrency>.

Cmcmarkets.com. n.d. What is Cryptocurrency? How do they work? | CMC Markets. [online] Available at: <https://www.cmcmarkets.com/en-au/learn-cryptocurrencies/what-are-cryptocurrencies>.

Danial, K., 2021. What Is Cryptocurrency? – dummies. [online] dummies. Available at: <https://www.dummies.com/personal-finance/what-is-cryptocurrency/>.

Rosic, A., n.d. What is Cryptocurrency? [Everything You Need To Know!]. [online] Blockgeeks. Available at: <https://blockgeeks.com/guides/what-is-cryptocurrency/>.

Royal, J. and Voigt, K., 2021. What Is Cryptocurrency? Beginners Guide to Digital Cash – NerdWallet. [online] NerdWallet. Available at: <https://www.nerdwallet.com/article/investing/cryptocurrency-7-things-to-know>.

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